Market Update: History Supports Optimism for 60/40 Portfolios
- Very difficult year unlikely to be repeated
- But remain cautious near term
- Higher for longer outlook still unfolding
2022 was one of the most challenging years in my many decades of investing. For the first time in history, stocks and bonds both declined by more than 10%. This highly unusual combination resulted in the traditional 60/40 portfolio — designed to offer a degree of downside protection in turbulent markets — posting an eye-watering 16.9% decline and its worst annual return since the Great Financial Crisis of 2008. We believe 2023 will ultimately turn out to be more positive for investors but remain cautious for now.
Looking closer at historical performance, we see good reason for optimism going forward. Since 1926, there have been only six years where the 60/40 portfolio mix has declined by 10% or more, and cumulative returns were higher in most cases six months later and significantly higher after one year and three years.
The real shocker though in 2022 was that bonds fell for the second year in a row, with their 13% decline the biggest in nearly 100 years. Prior to this, the most bonds declined in a given year was in the 6%–7% range, and this occurred only three times, with the average next year return for fixed income investors a very strong 8%.
So with history on our side, where do we go from here? The good news, after such a painful experience, is that the outlook for the year ahead is considerably brighter. However, we think investors will first likely need to exercise a bit more patience. From our perch, we see 2023 shaping up to be a tale of two halves, with the many factors that have weighed on markets this past year — persistently strong inflation, hawkish central banks, rising recession risk and ongoing geopolitical uncertainty — continuing before giving way to more favorable market conditions. Until then, there are several key issues we are watching.
At the top of our list is the path of Fed policy. While inflation trends are now moving favorably, they are likely happening too slowly for central bank officials. With wage and service sector pressures in particular proving stubborn, the Fed has continued to signal it plans to “hike and hold” rates at high levels. Investors, though aren’t buying it, with the market’s rally off its mid-October low premised on expectations that officials will pivot to cutting rates as soon as the second half of 2023. However, if as we expect, the Fed does stay on course keeping rates higher for longer, further volatility in the months ahead is likely.
Indeed, given the Fed’s determination to bring down inflation, a recession in coming months will be hard to avoid. Higher rates have already taken a significant bite out of economic activity, and due to the lagged nature of monetary policy transmission, the full effects of tightening have not yet been felt on the economy. From an investment perspective, what concerns us the most is that markets still seem to be pricing in a soft landing ahead, with 2023 earnings growth expectations a relatively healthy 4.2%. Our outlook calls for a -2.7% earnings decline on a weighted average basis, but in a scenario where the economy enters even a mild recession, we think earnings growth could potentially fall even further, up to 10%.
There are also many other things that could upset investor sentiment in coming months. We think a US debt default will ultimately be avoided; however political turmoil in Washington indicates resolving the latest debt ceiling crisis won’t come without some level of market volatility. At the same time, geopolitical concerns have not gone away. Russia’s war with Ukraine continues to rage on, and while the ending of China’s Zero COVID policy has so far gone better than expected, reopening is bound to be a bumpy affair. We remain in a risky environment, and though the US may be insulated to some degree from external shocks, as we’ve been repeatedly reminded over the past two years, what happens halfway around the world can have significant reverberations here at home.
Nevertheless, at some point over the next six to 12 months, we think investment conditions will likely begin to improve. Relative to the eve of prior recessions, US banks remain well capitalized, consumer and corporate balance sheets are healthy and the labor market is strong, all of which should help mitigate against the risk of a short and shallow economic downturn turning into something deeper and longer lasting. We also expect inflation to continue to show signs of sustained moderation, allowing the Fed to eventually pause their tightening campaign when the policy rate reaches around 5%. This won’t be a cure-all, but a Fed moving to the sidelines should allow the economy and markets to find more sustainable footing.
For now, we remain happy with the de-risking steps we’ve made over the past year in client portfolios and continue to maintain our cautious approach to asset allocation positioning. Importantly, we have yet to see that capitulation or “throw in the towel” moment that can typically occurs at the end of bear markets, and our focus on holding high-quality and income-producing US stocks and bonds can help provide client portfolios with relative stability until market turbulence subsides. Still, if we are right about all this, then we are also likely coming closer to the end of this painful reset in asset prices. In the months ahead, bonds may continue to struggle with rising interest rates, but higher rates have already brought a much-improved outlook for fixed income investors, who have not seen yields at these levels in many areas of the market in more than a decade. Likewise, though stocks may face additional downside pressures as earnings expectations are revised down, significant repricing has already occurred.
While it can be difficult, this is a good reminder for investors that it is important to focus not on where returns have been, but on where they could go in the quarters and years ahead. There is likely more volatility to come, and it’s not certain that we have seen the lows for this cycle, but we think it is increasingly probable that conditions will unfold for a more durable recovery into the second half of the year. However, a meaningful lowering of inflation and some earnings growth visibility will first likely be necessary before risk assets find their bottom. Until then, we remain patiently vigilant, watching for conditions and signals to improve.
Any opinions, projections, forecasts and forward-looking statements presented herein are valid as of the date of this document and are subject to change.
The information presented does not involve the rendering of personalized investment, financial, legal or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.
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Private investments often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important tax information.
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Investments in below-investment-grade debt securities, which are usually called “high-yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.
There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors, as well as increased volatility, lower trading volume and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.
There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in below-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.
Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.
Alternative investments are speculative, entail substantial risks, offer limited or no liquidity and are not suitable for all investors. These investments have limited transparency to the funds’ investments and may involve leverage which magnifies both losses and gains, including the risk of loss of the entire investment. Alternative investments have varying and lengthy lockup provisions.
This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment advisor and a wholly-owned subsidiary of City National Bank. City National Bank provides investment management services through its sub-advisory relationship with City National Rochdale.
S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria that the index includes.
Bloomberg Barclays US Aggregate Bond Index (LBUSTRUU): The Bloomberg Aggregate Bond Index or “the Agg” is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
GT2 Govt, GT3 Govt, GT5 Govt, GT10 Govt, GT30 Govt: US Government Treasury Yields
DXY Index: The U.S. dollar index (USDX) is a measure of the value of the U.S. dollar relative to the value of a basket of curren-cies of the majority of the U.S.’s most significant trading partners.
Dow Jones U.S. Select Dividend Index (DJDVP): The Dow Jones U.S. Select Dividend Index looks to target 100 dividend-paying stocks screened for factors that include the dividend growth rate, the dividend payout ratio and the trading volume. The components are then weighted by the dividend yield.
P/E Ratio: The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS).
The Commodity Research Bureau (CRB) Index acts as a representative indicator of today’s global commodity markets. It measures the aggregated price direction of various commodity sectors.
The MSCI indexes are market cap-weighted indexes, which means stocks are weighted according to their market capitalization — calculated as stock price multiplied by the total number of shares outstanding.
Quality Ranking: City National Rochdale Proprietary Quality Ran king is the weighted a verage sum of securities held in
the strategy versus the S&P 500 at the sector le vel using the below formula.
City National Rochdale Proprietary Quality Ranking formula: 40% Dupont Quality (return on equity adjusted b y debt levels), 15% Earnings Stability (v olatility of earnings), 15% Re venue Stability (volatility of revenue), 15% Cash Earnings Quality (cash flow vs. net income of compan y) 15% Balance Sheet Quality (fundamental strength of balance s heet).
*Source: City National Rochdale proprietary r anking system utilizing MSCI and FactSet data. **Rank is a perc entile
ranking approach whereby 100 is the highest possible score and 1 is the lowest. The Ci ty National Rochdale Core compares the weighted average holdings of the str ategy to the companies in the S&P 500 on a sector basis. As of September 30, 2022. City National Rochdale proprietary ranking system utilizing MSCI and FactSet data.
Rank is a percentile ranking approach whereby 100 is the highest possible score and 1 is the lowest. The City National Rochdale Core compares the weighted average holdings of the strategy to the companies in the S&P 500 on a sector basis. As of June 2022.
Bloomberg Barclays US Aggregate Bond Index: The Bloomberg Aggregate Bond Index or “the Agg” is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
The Case-Shiller Index, formally known as the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index, is an economic indicator that measures the change in value of U.S. single-family homes on a monthly basis.
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Taxable Strategies: Charles Luke Q1 2023
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